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Fidelity International's outlook for the new financial year

Paul Taylor/Amit Lodha  |  28 Jul 2016Text size  Decrease  Increase  |  

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While the Australian stock market is well positioned for financial year 2017, there are still plenty of economic headwinds and protecting capital should be the top priority.


Outlook from Paul Taylor, portfolio manager of the Fidelity Australian Equities Fund

While there still remain plenty of potential economic headwinds my belief is the Australian stock market is well positioned for financial year 2017.

There are numerous economic transitions happening around the world that add to heightened risk concerns.

China is transitioning from an infrastructure-led economy towards domestic consumption, in the US the Federal Reserve is trying to transition in higher interest rates, in Europe Britain has just voted to leave the EU, and even in Australia we are transitioning from an economy focused on investing in resources toward domestic consumption and services.

The Brexit vote as well as the rise of Donald Trump in the US also points to another big picture trend of the rise of protectionism.

The very close Australian federal election vote also makes for nervous consumers and corporates on the belief that it will be much more difficult to achieve any positive reform and more sub-optimal deals with minority parties will be required to run the government.

On top of these bigger picture transitions there is also nervousness around significant industry disruption from technological advances like artificial intelligence, virtual reality, augmented reality, e-commerce, power storage and even longer life.

It is important to note that even with these many transitions and disruptions the world generally seems to be heading in the right direction, albeit at a lower growth rate.

While the world may be low-growth for a prolonged period it is also important to note there will be very significant winners and losers underneath this low-growth facade.

Individual companies and sectors could see very significant growth or decline. Growth and sustainable yield will be very sought-after attributes and bid up by the market.

The Australian stock market is currently trading on long-term average valuation multiples. The Australian market is trading on a forward P/E ratio of approximately 15.5x and a dividend yield of close to 5 per cent.

While these valuation metrics are in line with long-run averages I actually believe they should be higher given the current environment.

I base this more optimistic premise on three key factors: 1) Low cash interest rates; 2) High-quality earnings; and 3) 10 per cent EPS growth expectations for 2017.

Low interest rates should mean high P/E ratios. The spread between the equity market yield and the cash yield is very high and we should see further equity market yield compression, which should mean higher P/E ratios.

I would argue that we currently have much higher quality of earnings. Debt levels are low, balance sheets are strong, and boards and management teams are conservative, which all means you are getting high-quality earnings at average valuations.

Finally, EPS growth expectations of around 10 per cent in 2017 would also point to attractive valuation levels.

In 2017, while bank and property earnings growth rates are expected to be in flat to low single digits, industrials should average around 10 per cent with even better growth coming from the resource sector.

While growth is expected to pick up in the resources sector it will be cyclical rather than structural, so not have the same impact on share prices.

Selected technology, services and industrials should do well in 2017 on good growth, and sustainable yield performance should continue in 2017 as cash rates remain low.

Some of the major overweights in the Fidelity Australia Equities Fund [12292] remain Wisetech (ASX: WTC), Suncorp (ASX: SUN), Seek (ASX: SEK), Rio Tinto (ASX: RIO), Oil Search (ASX: OSH), Goodman Group (ASX: GMG), Sydney Airport (ASX: SYD), Domino's Pizza Enterprises (ASX: DMP) and Commonwealth Bank of Australia (ASX: CBA).

Over the long term the Australian stock market has been the best-performing market in the world.

Some of the key drivers of this strong long-term performance have been factors like: strong population growth, a low-cost natural resource base, high corporate governance, and high dividend yields and high real dividend growth.

These key long-term factors are still very much in place looking forward and should set a strong platform for good Australian stock-market performance over the next decade.

There is no doubt some of the headwinds discussed earlier will cause volatility in Australian and global markets during 2017, but given underlying fundamentals the volatility may be viewed generally as a good long-term buying opportunity.

Outlook from Amit Lodha, portfolio manager of the Fidelity Global Equities Fund

Investors begin Australia's new financial year acknowledging it is likely to be bedevilled by political risk and that they are less adept at assessing such dangers than they are at judging macroeconomic and company fundamentals.

Political uncertainty means the odds of a global recession have risen because doubts about government policy undermine business confidence.

But policymakers will react. The Federal Reserve is likely to keep the US cash rate on hold until November's election, an outlook that favours bond-like equities (utilities, consumer staples and real estate investment trusts).

The other response will be more fiscal stimulus. China and Japan are likely to boost government spending, which would help sectors such as construction and commodities.

While the US economy appears sound and China muddling through remains the most likely outcome, riskier assets such as equities are unlikely to be as sought after as they were in recent years.

In spite of the uncertainty, it's possible to find companies that are undervalued because their ability to generate superior profits (due to their pricing power) is underappreciated.

People will still consume Coca-Cola, need medication and use Facebook, Google and Microsoft products.

There remain developments to play out such as virtual reality, gaming and the changes to business models that machine learning is bringing.

Due to underinvestment in energy, the next oil price surge is only a matter of time.

Overall, though, the message for the coming 12 months is that protecting capital should be the top priority.

It's mine anyway.

More from Morningstar

• Is the Italian banking system insolvent?

• Bond market rally shows no sign of ending


Paul Taylor is the portfolio manager of the Fidelity Australian Equities Fund and Amit Lodha is the portfolio manager of the Fidelity Global Equities Fund.

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